Defining risk through CRE bottom up stress tests
A bottom-up stress test is one in which the financial institution uses loan-level data from a sample of the portfolio to gauge the potential impact of a stress scenario on the institution’s earnings and capital. Once the sample has been selected—typically a portion of the CRE portfolio—the institution applies a set of assumptions to those loans to see how cash flow, debt service or loan to value figures change.
The estimated impact on these key ratios is then aggregated and extrapolated across the portfolio to see summary-level values and the impact on the institution’s financial statements and other Call Report data.
Whether the institution uses a complex set of spreadsheets for the analysis or a stress testing software, stress testing results from the bottom up analysis can be used to determine the potential change in capital levels and new capital ratios that the institution would have in the defined stress scenario. It will be these capital ratios that examiners use during a federal exam to determine if the institution is adequately capitalized or if additional capital reserves must be allocated.
A challenge with performing bottom-up stress tests is the level of financial and collateral detail required for loans. “I think a lot of banks are intimidated by the idea of gathering all of that data for a large portfolio or their entire CRE portfolio,” noted Liz Williams of CEIS Review, Inc., an independent consulting firm with expertise in loan review programs, ALLL and portfolio stress testing. But complete data coverage is not necessary from the start. “You do not need 100 percent coverage of the portfolio on Day-One,” Liz explains. Rather, focus on data collection for a manageable portion of the portfolio and start to establish processes, whether at loan review or origination, through which data can be collected more systematically. At the end of the process, bottom-up stress testing for an area of concentration can help the bank justify or support a concentration, such as CRE.
To find out more about concentration stress testing, download the whitepaper How Regulators Gauge Capital Adequacy Under Stress.